Investors invest in the stock market based on the odds of reward and risk, but the odds are not always easy to calculate. Multi-Act’s Quality of Earnings analysis is utilized to judge the congruence between the economic earnings

of the firm and the integrity of its balance sheet.

At Multi-Act, instead of looking at volatility (or volatility derived measures) As proxies for risk, we define risk in terms of:

BALANCE SHEET RISK BUSINESS RISK MARKET RISK

Thus, Quality of Earnings analysis (QoE) is used as a key element of identifying business risk.

We bring you 3 Case Studies that highlight Multi-Act’s diligent analysis of the Quality

of Earnings of a company that resulted in warnings signs well in advance of

the potential risk which emanated from the QoE analysis of such companies.

The key question is:

Does the Accounting Earnings of a FirmReflect the Economic Earnings? Does this, in Turn, Reflect a SoundBusiness Model?

Canadian specialty pharmaceutical company:‘High’ on high yieldThis large Canadian specialty pharmaceutical company was a market darling. Its debt funded acquisition led growth was cheered and rewarded by the market.

Our QoE analysis in April 2015 focused on:

Change in revenue recognition policy (at one acquired company): From ‘at the time of shipments to ultimate customer’ earlier to ‘at the time of shipments to wholesalers’.

High Intangibles on B/S: ~ 4 times its Net Worth; potential w/off in offing. Suggestive of aggressive capital allocation policy.

Deterioration in M-Score 2 from mid 2000s.

Recurring and large restructuring charges.

Hard to decipher sustainable/applicable tax rate.

Aggressive acquisition bid of another US based specialty pharmaceutical company, with similar QoE and Corporate Governance issues.

2009 2010 2011 2012 2013 2014

EBIT Interest cover 8.35 2.34 1.62 1.43 1.38 2.61

OCF Interest cover 15.21 3.92 3.02 2.36 2.23 3.36

Total Debt Tangible TA 74.1% 376.6% 446.7% 372.0% 384.6% 322.2%

Net Debt/ OCF 0.92 18.80 12.19 18.44 19.54 8.02

AZS 3.47 0.71 1.23 1.04 1.33 2.15

Total D/E 0.25 1.01 2.06 3.26 3.92 3.43

Net Debt/EBITDA 0.92 11.49 7.51 7.49 8.15 4.46

AGGRESSIVE B/SAlarming Debt to Equity ratio, poor AZS 1, poor debt servicing ratios etc .

Grade assignedby Multi-ActResearch Report

B-A B

(Ranges from A, B+, B, B- and C;wherein A is best and C is worst)

Ultimately the issues exploded upon some adverse news flows on its pricing practices followed by some damning reports on its accounting practices and corporate governance matters.

STEEL COMPANY MELTING DOWN

This is a prominent steel maker in India (amongst the top 5). On a client’s request, we had initiated research coverage on this company in Sept 2012

with a specific focus on its balance sheet. The stock was the market’s darling till mid-2014, as was

reflected in its outperformance against the steel sector pack.

While market focused on its top-line growth, aggressive capacity expansion and better than peers’ margins,our analytical conclusions revolved around following points:

Leverage driven growth and whetherthe growth capex was well spent

Significant amount of un-hedged foreign currency loans

Aggressive expense capitalization (boosting margins!)

Other parameters like M-Score, AZS and Cash Conversion Cyclealso reflected the balance sheet strain.

Apart from heavy borrowings to fund the capex, which causes a strainon the balance sheet, even the working capital cycle deterioration warranted caution

Cash Conversion Cycle 2005 2006 2007 2008 2009 2010 2011 2012

Receivable Days 47 54 52 54 46 49 26 45

Inventory Days 90 70 84 119 114 172 239 172

Payable Days 56 70 77 111 80 86 77 52

Total Days 81 55 59 63 80 136 187 165

Grade assignedby Multi-ActResearch Report

B-A B

(Ranges from A, B+, B, B- and C;wherein A is best and C is worst)

The high flying stock crashed significantly, owing to the weight of the debt on the B/S and fact that debt rolling-over the same beyond a limit became difficult and lenders became wary. Weak macro/industry environment added to the weakness emanating from the B/S

CURIOUS CASE OF INR 13,000m WRITE-OFF!This is a mid-size Indian Pharmaceutical company. Towards the mid-2014, it sold significant part of its operating ‘formulations’ business in India to a leading industry player.

While looking deep into its balance sheet, cash flow statement and schedules in notes to accounts, what caught our attention was that the full sale proceeds never reached the minority shareholders or the lenders of the company. Instead it appeared that the company made certain ‘advances’ thereafter, which were also written-off subsequently during the same quarter itself. Similarly there were some write-offs of certain ‘trade debtors’ as well.

PARTICULARS INR MILLION

Purchase Consideration 20,040

Working Capital Adjustments (422)

Net Purchase Consideration 19,618

Slump sale advisory expense (275)

Tax (2,000)

Net Consideration after taxes 17,343

Loss on sale of advances (10,316)

Sundry debtors written off (3,227)

Exchange Loss (88)

Net Exceptional Profit 3,713

The same then was indirectly confirmed by way of auditor’s qualifications in that regard.

Grade assignedby Multi-ActResearch Report

B-A B

(Ranges from A, B+, B, B- and C;wherein A is best and C is worst)

Subsequently there have been more adverse developments in the form of absconding directors; arrest of some directors for alleged fraud etc. and stock price continues to remain under pressure.

The said company also defaulted on repayment of principal and interest on certain deposits and sought time extension from CLB for repayments. That, for a company,

supposedly aflush with sale proceeds of its substantial business segment is well, hard to understand.

Our questionnaire to the company management in August 2015 on these issues went unanswered.

For more details on these case studies:

• A Specialty Canadian Pharma Company: High on High Yield

• Steel Company in News

• Rs. 1300 Crore Write-Off: Stakeholders Taken for a Ride

Multi-Act was founded in 1997 by two Wharton graduates, to develop an Equity Research capability for their own investments. Today, we employ 50 people who operate out of our offices in Mumbai and Pune and service a range of clients from wealthy families, family business owners to sophisticated investors and capital intermediaries around the globe.

Mumbai: +91-22-61408989 Pune: +91-20-66033142PMS: pms@multi-act.comAdvisory: research@multi-act.com